APPENDIX

NOTES FOR FOMC MEETINGMARCH 29, 1988

SAM Y. CROSS

FROM THE TIME OF YOUR LAST MEETING THROUGH EARLY

MARCH THE DOLLAR TRADED COMFORTABLY IN A RATHER NARROW RANGE.

THE FOREIGN EXCHANGE MARKETS WERE CALM, QUIET, AND OUT OF THE

HEADLINES. SUBSEQUENTLY, HOWEVER, NEGATIVE SENTIMENT TOWARDS

THE DOLLAR RE-EMERGED PARTICULARLY AGAINST THE YEN. BY LAST

FRIDAY, THIS SENTIMENT WAS WEIGHING SO HEAVILY ON THE DOLLAR

THAT WE AGAIN STARTED TO INTERVENE.

FOR SOME TIME AFTER YOUR FEBRUARY MEETING, THE DOLLAR

BENEFITTED FROM REASSURING INDICATIONS COMING FROM THE UNITED

STATES. THE TRADE FIGURES FOR DECEMBER SHOWED A CONSIDERABLE

IMPROVEMENT IN OUR NET EXPORT POSITION. OTHER ECONOMIC

STATISTICS SUGGESTED THAT THERE WAS LESS RISK OF RECESSION

HERE THAN HAD BEEN SUPPOSED AROUND THE TURN OF THE YEAR. AND

CHAIRMAN GREENSPAN'S CONGRESSIONAL TESTIMONY LEFT THE

IMPRESSION THAT THE U.S. ECONOMY WOULD EXPERIENCE MODERATE

GROWTH. AND THAT THE FEDERAL RESERVE WOULD REMAIN ALERT TO

CURB ANY INFLATIONARY PRESSURES THAT MIGHT ARISE.

AT THE SAME TIME, MARKET PARTICIPANTS REMAINED WARY

THAT THE CENTRAL BANKS WOULD INTERVENE ON EITHER SIDE OF THE

MARKET TO RESIST ANY SHARP DOLLAR MOVES. ON ONE OR TWO BRIEF

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OCCASIONS, MARKET SENTIMENT BECAME A BIT MORE CAUTIOUS AND THE

DOLLAR TRADED WITH A SLIGHTLY SOFTER TONE, IN PART BECAUSE OF

UNFOUNDED MARKET RUMORS THAT MAJOR CENTRAL BANKS HAD BEGUN TO

SELL SOME OF THE DOLLARS THEY HAD ACCUMULATED FROM EARLIER

INTERVENTION. THE SENSITIVITY OF THE MARKET TO RUMORS OF THIS

SORT REFLECTED CONCERN THAT THE MONETARY AUTHORITIES WOULD NOT

HAVE THE SAME APPETITE FOR BUYING DOLLARS IN THEIR INTER-

VENTION OPERATIONS THAT THEY HAD LAST YEAR, WHEN, IN EFFECT,

THE CENTRAL BANKS FINANCED THE BULK OF OUR CURRENT ACCOUNT

DEFICIT. BUT MARKET PARTICIPANTS, STILL MINDFUL OF THE

COORDINATED INTERVENTION OPERATIONS OF EARLY JANUARY, WERE

RELUCTANT TO TEST OFFICIAL RESOLVE, SO THAT SUCH PRESSURES AS

THERE WERE WERE TRANSITORY AND THE DOLLAR REMAINED RELATIVELY

STABLE.

THIS FAVORABLE SITUATION CHANGED AFTER THE BRITISH

AUTHORITIES, DECIDED TO UNCAP STERLING RELATIVE TO THE GERMAN

MARK, AND ON MARCH 7 ALLOWED THE POUND TO RISE ABOVE DM3.00.

THIS WAS THE LEVEL THAT THE BANK OF ENGLAND HAD DEFENDED

HEAVILY BOTH RECENTLY AND DURING MOST OF THE PAST YEAR. MANY

IN THE MARKET HAD ASSOCIATED BRITAIN'S EFFORTS TO KEEP

STERLING FROM APPRECIATING AGAINST THE MARK WITH THE G-7

COMMITMENTS TO FOSTER EXCHANGE RATE STABILITY, AND HAD

POSITIONED THEMSELVES ACCORDINGLY. THEY THEREFORE QUESTIONED

WHETHER THE CHANGE IN APPROACH BY THE BANK OF ENGLAND

SIGNIFIED AN EROSION OF THE RESOLVE TO HOLD EXCHANGE RATES

STEADY MORE GENERALLY. A FEW DAYS LATER, WHEN THE BANK OF

FRANCE TEMPORARILY LET THE FRENCH FRANC DECLINE WITHIN THE EMS

-3-

IN THE FACE OF A LARGE ORDER, MARKET OBSERVERS THOUGHT THEY

SAW YET FURTHER EVIDENCE THAT DOMESTIC POLICY CONSIDERATIONS

WERE GAINING IN EMPHASIS RELATIVE TO EXCHANGE RATE STABILITY.

THESE EVENTS HAD A STRONG EFFECT PARTLY BECAUSE THEY

OCCURRED AT A TIME WHEN QUESTIONS WERE ALSO ARISING AS TO

WHETHER UNDERLYING FUNDAMENTALS WOULD SUSTAIN A CONTINUED

REDUCTION IN THE GLOBAL IMBALANCES.

WITH RESPECT TO THE UNITED STATES, THE ECONOMIC DATA

BEING RELEASED DURING MARCH NO LONGER HAD SUCH A REASSURING

EFFECT ON MARKET PSYCHOLOGY. AS EVIDENCE BUILT UP SUGGESTING

THAT THE U.S. ECONOMY WAS STRONGER THAN HAD BEEN THOUGHT,

CONCERN DEVELOPED THAT DOMESTIC DEMAND MIGHT CHOKE OFF FURTHER

IMPROVEMENT IN OUR TRADE ACCOUNTS IN THE MONTHS AHEAD. PARTLY

FOR THIS REASON, THE RELEASE OF YET ANOTHER MONTH OF

RELATIVELY GOOD TRADE FIGURES IN MARCH, THIS TIME FOR THE

MONTH OF JANUARY, GAVE THE DOLLAR VERY LITTLE LIFT IN THE

EXCHANGE MARKETS. IN ADDITION, THERE WAS TALK OF BOTTLENECKS

DEVELOPING IN SOME AREAS OF THE ECONOMY--BOTTLENECKS THAT

MIGHT LEAD EITHER TO PRICE PRESSURES OR TO A RENEWED SURGE IN

IMPORTS.

WITH RESPECT TO GERMANY, ALTHOUGH DOMESTIC DEMAND AND

ECONOMIC GROWTH PICKED UP DURING THE LAST PART OF 1987, THE

GERMAN ECONOMY HAS CONTINUED TO BENEFIT FROM EXPANDING EXPORTS

TO OTHER EUROPEAN COUNTRIES, AND MARKET PARTICIPANTS HAVE

BEGUN TO WONDER ABOUT THE CONSEQUENCES FOR THE EMS. WITH THE

MARKET LESS CONFIDENT ABOUT THE STABILITY OF THE EXCHANGE RATE

STRUCTURE, THERE WERE AT TIMES SHIFTS OF FUNDS BACK OUT OF THE

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HIGHER YIELDING EMS CURRENCIES AND INTO THE MARK, AND RUMORS

OF A POSSIBLE EMS REALIGNMENT CIRCULATED FOR A WHILE IN EARLY

MARCH.

WITH RESPECT TO JAPAN, THERE WAS AND IS A WIDESPREAD

PERCEPTION THAT THE YEN COULD RISE SHARPLY. THAT VIEW IS

BASED ON A BELIEF THAT THE YEN IS BEING KEPT ARTIFICIALLY LOW

AHEAD OF THE JAPANESE FISCAL YEAR-END. PARTLY BECAUSE OF

BOOKKEEPING CONSIDERATIONS, AND THAT AFTER MARCH THE STRENGTH

AND COMPETITIVENESS OF THE JAPANESE ECONOMY AND BALANCE OF

PAYMENTS WILL REASSERT ITSELF AND CAUSE THE YEN TO MOVE

SUBSTANTIALLY HIGHER.

IN THESE CIRCUMSTANCES THE DOLLAR/YEN RATE BEGAN TO

COME UNDER PRESSURE. THE BANK OF JAPAN STARTED TO INTERVENE,

OPERATING IN SMALL AMOUNTS BUT VISIBLY FOR A COUPLE OF DAYS.

AT FIRST, THESE OPERATIONS HAD THE EFFECT OF REMINDING MARKET

PARTICIPANTS THAT THE CENTRAL BANKS MIGHT STILL INTERVENE, AND

SELLING PRESSURE AGAINST THE DOLLAR WAS CONTAINED. BUT BY

FRIDAY. THE MOOD OF THE MARKET DETERIORATED PROGRESSIVELY AND

THE DOLLAR HAD DECLINED TO ABOUT Y125. EXPECTATIONS WERE

BUILDING UP OF A NEW UPSURGE IN THE YEN AS SOON AS THE FISCAL

YEAR END HAD PASSED. THE DESK THEREFORE BEGAN TO INTERVENE ON

FRIDAY, BUYING $148 MILLION THAT DAY. PRESSURE AGAINST THE

DOLLAR, ESPECIALLY AGAINST THE YEN, CONTINUED AFTER THE

WEEKEND. WE AGAIN INTERVENED YESTERDAY, BUYING $200 MILLION

AGAINST YEN, BUT THE PRESSURES BECAME MORE GENERAL AND THE

DOLLAR WEAKENED AGAINST OTHER CURRENCIES. THIS MORNING, THE

DOLLAR IS TRADING AT Y124 .70 ND DM66.40 ABOUT 3½ PERCENT FOR THE

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YEN AND 1 ½ PERCENT FOR THE MARK BELOW THE LEVELS PREVAILING

AT THE TIME OF YOUR LAST MEETING. THE DOLLAR HAS EXPERIENCED

SELLING PRESSURE NOT ONLY AGAINST THE YEN AND MARK BUT ALSO

AGAINST STERLING AND THE CANADIAN DOLLAR AS INVESTORS NOW FIND

THOSE HIGH INTEREST RATE CURRENCIES QUITE ATTRACTIVE. LOOKING

AHEAD, THE PROSPECTS FOR THE DOLLAR REMAIN UNEASY, AND THERE

ARE WIDESPREAD VIEWS THAT THE PRESSURES WILL INCREASE AFTER

THE JAPANESE FISCAL YEAR ENDS ON THURSDAY.

Notes for FOMC MeetingMarch 29, 1988

Peter D. Sternlight

Domestic Desk operations since the February meeting of

the Committee have been directed at maintaining the slightly

reduced degree of reserve pressure sought in the days just before

that meeting. To be consistent with that slightly reduced

pressure, the path allowance for adjustment and seasonal

borrowing was reduced to $200 million at the February meeting,

and that level has been maintained in subsequent path

constructions, along with an associated expectation that Federal

funds would trade in the area of 6 1/2 percent. The Desk gave

slightly greater than "normal" attention to the funds rate in

day-to-day policy implementation, especially in the early part of

the period when we were seeking to ensure that the market really

got the message with respect to the recent slight easing. As the

period proceeded, and that message was driven home not only by

Desk operations, but also the Chairman's Humphrey-Hawkins

testimony, we returned increasingly to the "normal" focus on

reserve targeting, though never entirely ignoring the funds

rates.

In the three full reserve maintenance periods during

the intermeeting interval, the funds rate averaged 6.59 percent,

down from 6.82 percent in the previous period. While there was a

tendency for funds to be more often a shade above than below

6-1/2 percent, there were stretches of some days when the rate

was below that level. Currently, market participants seem to

expect the rate to center around 6-1/2 - 6-5/8 percent.

Borrowing averaged $238 million during the three reserve periods.

In two of them borrowing ran somewhat below the path level

through most of the period, only to bulge on the final day,

partly because of reserve shortfalls or relatively strong demands

for excess reserves. So far in the current period, borrowing is

averaging slightly over $200 million.

The broad money measures grew fairly robustly in

February and March, placing the M2 and M3 measures close to or

slightly over the top of the Committee's preferred 6 to 7 percent

range for these measures. M1 was weak in February, but resumed

growth in March with some accelerating gains in recent weeks.

While reserve needs were moderate during the period,

they were about as changeable as the weather from day-to-day,

causing the Desk to reverse direction within individual reserve

maintenance periods. One major change was the upsurge in

extended credit borrowing starting March 15, when a large Texas

bank turned to the Federal Reserve. We were generally apprised

about this in advance, but the precise timing was uncertain and

in that uncertainty we had to deal with reserve shortages in the

early part of that maintenance period, and also with the fact

that the market did not know that this reserve source would come

into play. Changeable estimates of required reserves also

affected the size and even the direction of our operations as

deposit growth alternately waxed and waned. On a commitment

basis, the System's outright holdings increased by about $370

million, chiefly reflecting small day-to-day purchases of bills

from foreign accounts. More sizable outright purchases would

ordinarily have been expected by this time of year, but this has

been delayed by the jump in extended credit borrowing. Meantime,

2

the Desk arranged about a dozen rounds of customer related

repurchase agreements and several rounds of matched-sale purchase

transactions in the market to add or drain reserves temporarily.

Incidentally, a very large reserve need is expected in the next

intermeeting period, especially after the mid-April tax date.

So far at least, the upsurge in extended credit does

not seem to have produced a significant change in bank attitudes

toward using the discount window, as it appeared to do after the

heavy Continental Bank borrowing in mid-1984. This may be

because attitudes toward borrowing have already been quite

cautious, and because the heavy Texas borrowing came as no great

surprise to the market. Also, adjustment and seasonal borrowing

was much greater just before the Continental problem (around $1

billion) so that more banks were being pressed to borrow and that

widened the scope for changed attitudes to show up.

At the time of the last Committee meeting, in early

February, the fixed income markets had been coming through a

strong price rally, based on estimates of subdued economic

growth, dampened inflation prospects and some speculation on the

possibility of a more accommodative monetary policy, either in

prospect or perhaps already underway. That rally halted around

the time of the meeting, however, as incoming economic news

suggested greater business strength than was anticipated earlier,

along with some scattered signs of greater price pressures. The

market got a temporary lift in late February from the combination

of what were seen as fairly accommodative Desk actions and the

Chairman's acknowledgement at the Humphrey-Hawkins hearing that a

slight easing move had been made a few weeks earlier. But

3

sentiment soon soured again, particularly after the strong report

on February employment, released in early March. While accepting

the fact that policy had eased a bit around late January, market

participants now saw little or no prospect of further

accommodation, and while not looking for any imminent firming

either, it was considered more likely that subsequent moves, when

made, would be toward the less accommodative side.

In that setting, intermediate and longer term Treasury

rates backed up by about 20 - 50 basis points over the period.

The Treasury's benchmark 30-year bond, which yielded 8.35 percent

just before the last meeting, climbed above 8.80 by the end of

the interval, with some backing and filling in the last few days

as bond prices recovered somewhat in response to weakness in the

stock market, but then gave ground as the dollar came under heavy

pressure. The Treasury raised about $10 billion through coupon

issues during the period -- relatively moderate by recent

standards.

In the bill market, rates rose by a more modest 10 to

20 basis points, reflecting the sustained fairly comfortable

funds rate, and a bit of flight to quality -- especially in the

latter part of the period when concerns were expressed about

various financial institutions. There was also a continuing

technical shortage of bills; regular 3, 6 and 12 month bills were

paid down, net, by about $1 billion, although the Treasury also

auctioned $4 billion of short-term cash management bills last

Friday, and will sell $9 billion additional cash management bills

tomorrow. All these cash management bills will mature April 21.

In yesterday's auctions, 3- and 6-month issues went at about 5.69

4

and 6.00 percent, compared with 5.63 and 5.85 just before the

last meeting.

Quality concerns also showed up in the Federal agency

market, most noticeably for the issues of FICO, the corporation

set up to borrow funds to bolster FSLIC's dwindling resources.

The spreads on outstanding FICO issues widened from about 90 to

105 basis points over comparable Treasury maturities as a growing

sense of the extent of deep losses among FSLIC-insured

institutions cast increasing doubt on the adequacy of that

insurance fund.

Some greater selectivity and widening of quality

spreads also showed up in the market for bank-related paper,

traceable to some extent to a number of downgradings of major

money center banks, although the rating changes themselves came

as no great surprise to the market. Reports on the troubled

banking situation in Texas also affected market attitudes, with

some adverse impact on bank holding company paper, although these

developments, too, did not elicit much surprise.

As market participants look ahead and appraise rate

prospects over coming quarters, the recession hypothesis for 1988

-- never more than a minority view in any event -- has virtually

vanished. At the same time, few see really strong economic

growth -- say as strong as last year's 4 percent rate -- but a

number see sufficient growth to begin exerting more noticeable

price pressures, even though they acknowledge that such pressures

are not widely visible yet. Those observers typically look for

somewhat higher rates ahead. A number of other analysts see the

moderate growth but believe it need not generate greater price

5

pressures and a minority would see room for rates to come down

somewhat as the year progresses.

Leeway Request

As I mentioned earlier, we face very large reserve

needs in the next several weeks, stemming chiefly from a rise in

Treasury balances at the Fed after the mid-April tax date. It

may rival last year's increase, although current expectations

would place it below that. An additional uncertainty this time

is the prospect for extended credit. If that grows further it

would lessen the need for System purchases of securities. We

would expect to meet a sizable chunk of the reserve need with

repurchase agreements, which don't count against leeway, but to

allow for ample flexibility I recommend a temporary enlargement

of the usual $6 billion leeway to $10 billion, until the next

Committee meeting date.

March 29, 1988

IMPLEMENTATION BRIEFINGDonald L. Kohn

I have only a little to add to the memo from Peter and me

distributed as background for discussion. The issues raised at the last

meeting on policy implementation fell into three categories--the degree of

emphasis on federal funds rates or borrowing objectives in day to day open

market operations, the scope for intermeeting adjustments in policy, and

partly related to the other two, the frequency of Committee meetings.

The basic arguments on the funds rate/borrowing issue have been

developed and discussed in past memos and at recent FOMC meetings. The

fundamental point is that the focus on borrowing adds an element of loose-

ness to the relationship between open market operations and the federal

funds rate. Most of the time, this doesn't matter very much. Over time,

the Desk can hit its borrowing objectives and federal funds should trade

near Committee expectations; if they don't, the borrowing objective can be

adjusted. The market recognizes the room for small fluctuations in

federal funds rates implied by this operating objective, and as a

consequence such fluctuations generally don't have a significant impact on

other variables.

At other times, the looseness does matter. Ocassionally, it can

contribute to the difficulties market participants may have in discerning

the intentions of the Federal Reserve, at least for a time. On the

other hand, the movements in the funds rate can tell us something about

market expectations, as well as about other forces of supply and demand

working on the market, that may be useful to policy makers. The tendency

of the funds rate to fluctuate somewhat can help the Federal Reserve make

small policy adjustments without drawing the kind of exaggerated reaction

that a narrow focus on the federal funds rate in open market operations

may engender. In any case, the scope for either desirable or undesirable

effects under a borrowing objective is fairly limited, given the tendency

noted above for the federal funds rate to line up with Committee

intentions over time.

A decision on the approach to open market operations obviously

depends on a weighing of these pros and cons. Although the memo and some

of the discussions tend to lay this issue out by contrasting the two

extremes, it may be useful to bear in mind that in practice the FOMC has

been moving along a continuum with different weights on the two objec-

tives, but in recent years rarely at one end or the other. Even when

using borrowing objectives, the Desk has taken into account the level of

the federal funds rate, both as an indicator of underlying reserve

conditions to supplement the reserve factor projections, and because it

has wanted to avoid, when possible, misleading the market about our

intentions. Since year-end, more emphasis has been placed on borrowing

than immediately after the stock market collapse, but given the state of

the markets and directives from the FOMC, federal funds rates have

received a little greater weight than before October. The movement back

along the continuum hasn't been reflected in increased federal funds rate

variability, perhaps because the market has had a reasonably good idea of

Federal Reserve policy intentions. Still the Desk has felt less obliged

to lean against small deviations in the funds rate from expectations than

it did over the last two months of the year. The fairly settled behavior

of the federal fund rate recently also has been mirrored in a tendency for

borrowing to stick relatively close to path once the path had been

adjusted for the continuing greater reluctance of banks to use discount

credit.

With regard to the scope for intermeeting adjustments in policy,

the questions are how much flexibility should the manager have in

consultation with the Chairman, and what form should notification of the

Committee take. That is, when is a telephone conference call a desirable

supplement to the information contained in the daily wires and biweekly

desk reports. Perhaps the issue here is more one of clarification of

existing arrangements than of changes in them.

The last issue involves the frequency of meetings. Any decision

on this may depend in part on the discussion of the previous issues. The

flow of economic and financial data may not call for more meetings,

especially given the availibility of the conference call to address

unusual situations, but a closer focus on the federal funds rate, or a

decrease in leeway for intermeeting adjustments, may warrant shorter

intervals between scheduled meetings.

Michael J. PrellMarch 29, 1988

FOMC BRIEFINGU.S. ECONOMIC OUTLOOK

As you know, there has been a noticeable change in the profile

of the staff's forecast since last month. While we still are projecting

a considerable slowing in growth from the late 1987 pace, the first-half

advance in real GNP now is a bit more than 2-1/2 percent at an annual

rate, versus 1-1/2 percent in the February chart show. Because that

greater increase in output brings with it somewhat higher levels of

resource utilization than previously expected, we envision some

additional inflationary pressure, manifesting itself later this year and

into 1989.

As a consequence, interest rates are now projected to rise

faster and farther than in the last forecast: we've built in a fed funds

rate of around 7-1/2 percent by early next year, with the yield on the

long Treasury bond moving into the 9-1/2 percent range. That rise in

rates tends to restrain activity, especially in the housing sector, but

directly and indirectly elsewhere too, so that after increasing about

2-3/4 percent in 1988, real GNP grows a touch less than 2-1/2 percent in

1989.

Looking at the recent period, the incoming data--especially

those on employment--have pointed to substantially more growth in the

first quarter than we showed in the last Greenbook. Indeed, if one were

to look only at the labor market figures, one would be tempted to write

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down a real GNP increase a percentage point or more above the 2-3/4

percent figure we've indicated. In that sense, the situation is

reminiscent of what we faced last fall, when there was a similar tension

between the available labor data and what we could see in the expendi-

ture figures--a tension that was eventually resolved in favor of the

strong labor data. We can't rule out a repetition of that experience in

the current quarter, but employment gains in manufacturing have been

smaller of late, and industrial production looks to be increasing at not

much more than half the 7 percent pace of the fourth quarter. Without

more goods production, it seems less likely that we'll find major upside

surprises in the inventory or net export data where our information is

most fragmentary at this stage.

The greater-than-expected strength in the first quarter raises

the question of what happened to the anticipated drags from the stock

market drop and from the inventory overhang. On the former, we noted in

the Greenbook supplement that, while consumer spending has run above

projection, disposable income has too, by a similar amount. It is the

behavior of the personal saving rate that is perhaps the best index of

the effect of the loss in stock market wealth, and the jump in that rate

has been fully as large as we had anticipated in our post-crash forecast

adjustments.

On the inventory issue, the speed with which auto dealer stocks

have been reduced has surprised both us and, evidently, the U.S. manu-

facturers. Sales have been fairly strong, probably reflecting rebound-

ing consumer confidence as well as the special incentives, and pro-

-3-

duction has been low. Last Friday, manufacturers announced upward

revisions to car assembly schedules that already had pointed to a

sizable pickup in production; this suggests the possibility that

increased auto output will provide even more than the 3/4 percentage

point boost to GNP growth built into our forecast for the second

quarter.

On the non-auto side, our guess--and it is little more than

that, given the limited data in hand--is that inventory investment will

be roughly the same in the first quarter as in the fourth. This does

raise the risk that inventory trimming could restrain output growth in

the months ahead, but our assessment is that the drag from such efforts

will be modest. First, revised data on retail sales and inventories

suggest that the overhang may have been more limited than we thought;

second, in some of the sectors--such as apparel and home goods--where

there appeared to be excess stocks, domestic production adjustments have

been occurring; third, we think some of the overhang will be relieved

through reduced imports; and fourth, price cutting has been used to

scale back undesired inventories, as indicated by the decline in the

apparel component of the February CPI. At this point, we are looking

for slower non-auto inventory accumulation in the second quarter, but

with the swing amounting to only a little over half a percent of GNP.

Returning to the first quarter, though, one may ask what has

provided the impetus to employment and income growth if consumers and

automakers pulled back as much as expected. The lesser efforts to trim

non-auto inventories are one part of the story. Another appears to be a

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stronger demand for business equipment. Orders and shipments of non-

defense capital goods have moved erratically, but appear to be up

appreciably on balance in recent months--with particular strength in the

computer and office machine category. How much of this production will

show up in domestic capital spending and how much in exports is unclear;

it is our sense that both of these expenditure categories have been

providing substantial support to economic expansion and will continue to

do so over the remainder of the year.

The positive outlook on exports is not new, but our projection

of business fixed investment has been revised up noticeably. The

McGraw-Hill survey taken between late January and early March showed

business planning almost a 9 percent increase in nominal outlays this

year, up from just over 6 percent in their fall poll. We suspect that

the apparent resilience of the economy in the face of the stock market

drop and a growing belief in the improved international competitiveness

of the United States may be prompting businesses to think more posi-

tively about the wisdom of upgrading and expanding capacity. In the

staff's forecast, the upward revision in BFI accounts for three-quarters

of the added 1988 GNP growth.

The McGraw-Hill survey shows especially large spending

increases in manufacturing industries where capacity utilization has

reached high levels. This is important if we are to have a smooth

adjustment of our external imbalance, without strong inflationary

pressure. But we see the overall capacity utilization rate edging

-5-

higher over the remainder of this year, and believe that this develop-

ment--along with rising prices for oil and for non-oil imports--will

contribute to some acceleration in prices.

In labor markets, the unemployment rate has dropped lower than

we expected, and we have carried that lower rate through the forecast

period. We have made a rather modest adjustment to the compensation

forecast, about matching the increment to the price forecast. The

reduced jobless rate does, however, move us down relative to the natural

rate--possibly even below it--and raises the odds that real wages will

be under more upward pressure than we have anticipated. While we have

compensation gains increasing from the 3-1/2 percent rate of the second

half of last year to 4-3/4 percent next year, many models would say

that--with the consumer price inflation we've forecast--the acceleration

of wages would be greater by a percentage point or more.

E.M.TrumanMarch 29, 1988

FOMC Presentation -- International Developments

As Mike has indicated, the broad contour of the staff's

outlook for the U.S. external sector is little changed. We

continue to see exports as a source of strength to domestic

production. However, because of the upward revision to our near-

term outlook for domestic sources of demand, we have become

somewhat more concerned about potential pressures on capacity and

about whether such pressures will show up in the form of higher

prices and lower quantities of exports.

We also have revised up slightly our outlook for

economic activity in the major industrial countries abroad. Data

released since early February indicate that growth in most of

these countries in the fourth quarter of 1987, while generally

slowing from the rapid pace of the third quarter, was faster than

we had expected. Meanwhile, available information on orders,

sales, and production in the first quarter suggest that the

growth has slowed further but remains in the range of 2 to 2-1/2

percent on average. As a consequence, we have raised our

forecast for the level of economic activity in the major foreign

industrial countries by about 1/2 percentage point over the

forecast horizon.

With respect to exchange rates, we almost made it

through a quarter of calm in the markets. However, as Sam Cross

reported, we seem to be caught up in another bout of dollar

weakness. We have not altered our basic outlook that the foreign

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exchange value of the dollar in terms of the other G-10

currencies will decline moderately on average over the next two

years. [In answer to Chairman Greenspan's earlier comments, this

moderate and gradual depreciation is not expected to add

significantly to capacity pressures at the aggregate level,

especially in 1988 and even in 1989. A more concentrated and

substantial depreciation would increase those pressures. For

example, our rule of thumb would suggest that a 10 percent

depreciation of the dollar now could add 2 to 3 percent to

demands for goods output by the end of 1989.] Returning to the

outlook for exchange rates, we have altered our outlook for the

dollar in terms of currencies of some of the developing

countries; we are now anticipating a faster rate of real

depreciation against the Korean won and the Mexican peso.

The merchandise trade deficit for January was

essentially unchanged from the December deficit on both a

seasonally adjusted and a not-seasonally adjusted basis.

However, the deficit was $20 billion lower at an annual rate than

the deficit in the fourth quarter of last year. Although this

trend in the balance is encouraging, especially since it was

coupled with substantially lower non-oil imports, the lower level

of non-agricultural exports was a bit disappointing.

On balance, we are expecting a significant improvement

in the trade balance in both nominal and real terms in the

current quarter. We believe that a large chunk of the

improvement will be associated with lower quantities of imports

-- non-oil as well as oil. The lower non-oil imports, in part,

- 3 -

are associated with the runoff of inventories built up in the

fourth quarter. For the balance of this year, we expect imports

to expand gradually in real terms, and we also expect the price

of petroleum imports to recover. As a consequence, we are

projecting that the nominal trade deficit will remain around the

first quarter's $140 billion at an annual rate for the remaining

quarters of 1988 before narrowing further in 1989. However, the

trade deficit should continue to improve in real terms.

As for the current account, the deficit in the fourth

quarter of last year was smaller than in the third quarter by

about $18 billion at an annual rate. However, this improvement

was more than accounted for by estimated net capital gains on

U.S. direct investments abroad that were associated with the

dollar's substantial depreciation in the fourth quarter. The

sharp reduction in such capital gains in the current quarter will

largely offset the expected improvement in the trade balance.

Thus, we are projecting that the current account deficit will

show little improvement this year from the $156 billion annual

rate deficit of the fourth quarter of 1987 but will decline by

about $25 billion over the course of 1989.

Unfortunately, such a trend of only gradual and

underlying improvement in our external accounts during 1988 may

not be well received by financial markets.

Mr. Chairman, that concludes our reports.

March 29, 1988

POLICY BRIEFINGDonald L. Kohn

Developments in financial markets since the last FOMC meeting

were marked by movements in a number of variables that seemed to

reflect a veiw that the economy was stronger and the risk of

inflation somewhat greater than previously had been anticipated. As Sam

and Peter have already discussed, much of the movement in interest and

exchange rates seemed keyed to the strength of incoming economic data.

The rise in bond yields is consistent with some combination of higher real

rates owing to greater real demands and an uptick in inflationary

expectations. The drop in the dollar may suggest not only concerns about

the effects of stronger demands on the external adjustment process, but

also that any real rate component to the rise in bond yields was at most

negligible. The recoupling in recent days of the dollar and the bond

market certainly is reminiscent of the pattern of the first three quarters

of 1987 when concerns about inflation tended to dominate market reactions.

In addition, growth of the money supply was relatively rapid in

recent months--somewhat more so than anticipated at the last FOMC. Much

of the strength in money supply growth was expected, as an aspect of the

easing of policy since last October. The decline in market interest rates

since then relative to yields on monetary assets has prompted greater

flows into these assets, especially those included in the broader

aggregates. As a consequence, velocity leveled out and may even have

declined a little in the first quarter. The overshoot of money relative

to projections at the time of the last FOMC, however, may also be a

product of unanticipated strength in the economy as reflected in flows of

nominal income and savings.

One probably shouldn't make too much of these developments,

either with respect to market rates or the money supply. The dollar

remains above and bond yields below levels of last December, and recent

movements could easily be reversed by new, weaker, economic data or even a

different tone to the Biege book. And the pick up in money stock growth

follows a long period of sluggish expansion. But these developments do

mark some shift in sentiment and outlook in financial markets. In effect,

they represent a re-evaluation of previous policy actions, which are now

seen as consistent with a somewhat more expansive economy than when they

were undertaken. Such a re-evaluation has had implications for market

expectations about the future course of monetary policy. Certainly, the

steepening of the yield curve suggests that markets are now a little more

inclined to the veiw that the next move will be in a tighter direction.

And the staff forecast, as Mike has noted, also encompasses some firming

of money market conditions over coming quarters, though not necessarily

beginning in the current quarter. In the forecast, nominal, and to some

extent real, interest rates are seen as needing to rise from current

levels to keep inflation pressures in check.

In this environment, money growth is expected to slow from the

pace of recent months. In the bluebook, a significant month by month

moderation of money growth is expected through June, even if, as under

alternative b, interest rates remain close to current levels. Portfolio

responses to the previous decreases in market rates should be winding

down, and opportunity costs of M2 could even rise a little as deposit

rates continue to adjust downward with a lag. In addition, high money

growth rates over the months of the first quarter left ample funds in the

hands of depositors to finance spending over coming months. This is

indicated by the projected increase in M2 growth on a quarterly average

basis in the second quarter, and appreciable decline in velocity.

In the staff forecast, money growth moderates further over

the second half of the year to just above the middle of the range,

reflecting the effects of the assumed rise in interest rates. If rates

don't move up, and the economy turns out to have something like the

strength in the staff forecast, both the money stock and the economy would

be expanding more rapidly. This circumstance would contrast with that of

the last several years. In 1985 and 1986, strong money growth accompanied

a relatively restrained economy and declining inflation rates, and in 1987

weak money growth was associated with a fairly strong economy and renewed

concerns about inflation. In both of those episodes, the Federal Reserve

took interest rate actions to lean against the prevailing forces in the

economy and those actions had a dominant effect on the aggregates. As a

consequence, the strength and weakness in money were not indicative of

developments in the economy. This year, in part because of the easing

after Ocober 19, there seems to be a possibility that we will get both

strong economic growth and rapid expansion in the aggregates. Of course

incoming information on the aggregates would have to be interpreted with

care, in light of other information about the economy and the possibility

of shifts in the underlying demand for money. But in these circumstances

the aggregates may once again play their more traditional role of alerting

the central bank that its provision of liquidity may not be entirely

appropriate to the emerging economic situation.

With regard to directive language, one issue is the special

sentence calling for flexibility in the execution of policy. In many

respects, markets are about as "normal" as they are likely to get for some

time, the economic outlook probably is no more uncertain than usual and

the borrowing/funds rate relationship seems to have stablized a little.

If the sentence is deleted, it would not necessarily imply that the

manager should ignore potential developments in borrowing behavior or

financial markets. These markets remain somewhat skittish, as suggested

by developments late last week, and there is the possibility of the

problems of Texas and other depository institutions affecting other

institutions or markets. An additional complication is the relatively

low level of borrowing now used as an objective. As you may have inferred

from the tortured explanation in the bluebook, the staff had difficulty

deciding to what level borrowing should be reduced consistent with

alternative A. The problems are that we are already close to frictional

borrowing, that the level of frictional borrowing may be rising as

seasonal borrowing rises in the spring, and that we have had little

experience running at borrowing close to frictional amounts. At these

levels, which could include alternative B as well as altternative A, the

funds rate may be particularly sensitive to shifts in borrowing propensi-

-5-

ties or difficulties in estimating borrowing relationship. Given these

possibilities, the Committee may want to instruct the desk to be sensitive

to such influences in carrying out policy, even if the special sentence is

not retained.

BOARD OF GOVERNORSOF THE

FEDERAL RESERVE SYSTEM

Office Correspondence Date March 25, 1988

To Federal Open Market Committee Subject Issues in the Implementation of Open

From Donald Kohn and Peter Stemlight Market Operations

At the last meeting of the Committee several issues were raised

about the implementation of open market operations. These included the

degree of emphasis on federal funds rate or borrowing objectives in day-

to-day operations, the frequency of Committee meetings, and the discretion

of the Manager and Chairman to make changes in policy between meetings

without formal consultation with the Committee. A discussion of the

approach to policy implementation has been scheduled for the March meet-

ing. As background for that discussion, this memo briefly reviews the

advantages and disadvantages of the current approach to each of these

issues and some possible alternatives. (An attachment to this memo

prepared by Ann-Marie Meulendyke of the Desk reviews the use of various

indicators in policy implementation over the last 30 years.)

FEDERAL FUNDS RATES AND BORROWING

Recent experience. In the immediate aftermath of the stock

market drop in October, the Desk concentrated much more than usual on the

federal funds rate and other indicators of market conditions in the day-

to-day implementation of policy, and much less on achieving an established

objective for adjustment and seasonal borrowing. This was done to help

stabilize markets and minimize the chances that the Federal Reserve's

intentions would be misinterpreted while markets were in an extremely

sensitive condition. As markets became less skittish, the Desk returned

to more normal operating procedures, especially'after year-end. However,

adjustments in borrowing assumptions were made, not only to effect changes

in the stance of policy, but also to take account of shifts in the

willingness of depository institutions to be seen at the discount window

and of other special factors affecting the use of discount credit.

The data shown in the charts and tables suggest that deviations

of both the federal funds rate and borrowing from expected levels

increased immediately following the stock market collapse. Day-to-day

funds rate variability declined substantially over the balance of 1987,

though this is not fully reflected in the data shown in the chart, which

are influenced by large deviations on the last day of statement periods.

On several such days in the latter part of 1987, the funds rate dropped

substantially owing to efforts earlier in the maintenance period to lean

on the side of oversupplying reserves to forestall unwanted tautness in

money markets. (The middle columns of Table 1 do not include Wednesday

data.) Borrowing (Chart 2 and Table 2) dropped relative to expectations

and to model results as market uncertainties apparently added to the

reluctance of depository institutions to be seen at the window. Bor-

rowing levels in the path were revised down to capture the shift in the

borrowing function, but through the end of the year, such adjustments were

inadequate to capture behavior fully.

Even as the focus of open market operations shifted back toward

borrowing after year-end, the variability of the federal funds rate around

expected levels did not increase. The Desk still is placing slightly more

weight than pre-October 19 on this indicator in conducting daily open mar-

ket operations. Borrowing has remained low, abstracting from some special

situations around year-end and a couple of instances of settlement day

pressures. Evidence over the last few statement periods suggests that the

reluctance to use the window is not as pronounced as late last year, and

that the adjustments made to the borrowing assumption have roughly taken

account of the remaining shift. Once these adjustments have been made,

borrowing has shown no increase in variability around expected values as

compared with the experience prior to the stock market crash.

Advantages and disadvantages. The principal disadvantage of

concentrating on achieving a borrowings objective is that the resulting

federal funds rates may deviate from the level the Committee thought would

be associated with the level of borrowing. As discussed in previous

memos to the Committee, borrowing objectives may not be achieved for a

variety of reasons, and if achieved may not be associated with the

expected federal funds rate, reflecting among other factors market

expectations about policy and changes in the willingness of depository

institutions to use the discount window. On average over time, the Desk

is able to meet borrowing targets; these targets, in turn, can be

adjusted, if needed, to take account of lasting shifts in the borrowing

function, so that federal funds rates should come out on average close to

the Committee's expectations. And even in the short run, the Desk can

compensate to a degree for a variety of temporary factors in implementing

policy. But especially over short horizons, federal funds rates still

will vary somewhat from expected levels.

1. This section is drawn from the memorandum of December 11, 1987 tothe FOMC entitled "Strategies for Open Market Operations".

To the extent that these variations are relatively small and

temporary, they probably would not have any significant effect on markets

under most circumstances. But at times they can lead to a misperception

of the Federal Reserve's intentions. Difficulties in achieving borrowing

levels or the effects of market expectations on the borrowing/funds rate

relationship can delay the impact on money market rates of policy actions

to ease or tighten, or lead to market perceptions that a change in policy

has occurred when none in fact was intended. In general, such misper-

ceptions are corrected fairly quickly when the Desk follows its borrowing

target. But if they do persist, or a shift in the underlying borrowing

relationship is recognized only with a substantial lag, the funds rate can

deviate for a time from Committee intentions. And it is money market

rates, rather than the division of reserves between borrowed and non-

borrowed components, that have the most direct impact on other financial

variables in markets--such as long-term interest rates, exchange rates,

and money growth--through which monetary policy is transmitted to the

economy.

Specifying a narrow federal funds rate target as the short-run

objective of open market operations clearly would avoid these difficul-

ties. Such a target could be achievable with a fair degree of accuracy,

especially if the Desk were to return to the procedures of the 1970's in

which it occasionally engaged in open market operations several times each

day. This would keep the funds rate generally between narrow intervention

points that the market could readily discern. Questions about the current

stance of the Federal Reserve would not be eliminated, but they would

probably be much less frequent.

The tendency for federal funds to trade very close to the Federal

Reserve's expected range, however, is also the primary disadvantage of

this procedure. Such an approach allows very little scope for market

forces to show through in the federal funds market. These forces, while

sometimes complicating the conduct of policy under a borrowing procedure,

can also be beneficial to policy implementation, more broadly considered.

Movements in the federal funds rate can convey information to policymakers

about expectations and other aspects of financial market conditions. And

these movements often will be in a stabilizing direction, as when a

firming in the funds rate in response to strong economic or money supply

data correctly anticipates a tightening action. A narrow focus on the

funds rate tends to smother such market-generated reactions, leaving the

policymakers looking at a mirror rather than at one potential indicator of

underlying forces in the economy.

The combination of a relatively stable federal funds rate and the

greater focus and identification of policy with this rate may also impart

an undesirable degree of inertia to the policy process. Because small

changes in the rate can come to be seen as signifying important shifts in

Federal Reserve policy, they can become more difficult to make. Decisions

to change the federal funds rate target may be especially difficult at the

present time, when lack of confidence in the properties of the monetary

aggregates has meant that any such adjustments normally are made only

after consideration of a wide variety of indicators, which inevitably give

more or less conflicting signals. The danger would be that responses to

emerging forces of inflation or deflation would be further delayed. Under

a borrowing objective, market forces would have some, albeit limited,

scope to lead money market rates in the appropriate direction.

INTERMEETING CONSULTATIONS

Since the late 1960's the directive has allowed for adjustments

in policy without a Committee meeting during the period until the next

scheduled meeting. The weights that should be placed on various types of

information in making such adjustments and whether the Manager should be

more inclined to ease or tighten in response to incoming data usually is

extensively discussed at the meeting, and is capsulized in the directive.

This flexibility allows policy to respond quickly should new data and

developments in markets warrant, without a full Committee meeting. The

understanding has been that any such moves would be made in consultation

with the Chairman, would be relatively minor in size, and would be in

accord with the contingencies discussed in the directive and at the

meeting. In practice in recent years, this has meant moves of something

like $50 to $100 million in the borrowing objective, which has typically

been thought of as equivalent to a change of about 1/8 to 1/4 percentage

point in the expected trading level of the federal funds rate. More

substantial moves, or even in some conditions moves of the foregoing size,

have been seen as calling at least for intermeeting consultation, and

sometimes for a formal meeting of the Committee. Obviously, any inter-

meeting moves would be covered in detail in daily wires and periodic Desk

reports, as well as thoroughly reviewed at the next full meeting of the

Committee.

If the Committee is of the view that this arrangement has been

satisfactory, it could be left unchanged. The Manager would be understood

to have some discretion to make relatively small intermeeting changes in

the System's open market stance in consultation with the Chairman, who

would decide whether such a policy shift were of sufficient interest or

significance to warrant a telephone conference call to report to or

consult with the Committee.

If the Committee felt that policy had not been well served by

this degree of discretion, it could be narrowed. In the extreme, the

sentence discussing intermeeting adjustments to policy could be deleted

from the directive, in effect mandating a Committee meeting and vote for

every change in policy, no matter how small. The danger is that small

moves would become more difficult to make, slowing the policy response to

changing conditions.

Alternatively, flexibility could be maintained, but the Committee

could arrive at a more precise understanding of when and how it should be

informed or consulted. For example, the Committee might conclude that it

ought to be informed via telephone conference about any policy moves as

large as $50 or $100 million in the borrowing assumption (or its equiv-

alent in the federal funds rate if the Committee wishes to emphasize that

in its operating strategy), and formally consulted beforehand on anything

larger. Presumably, the Chairman would have the prerogative to authorize

larger changes in an emergency situation. Such an understanding might be

embodied in a new version of the last sentence of the directive, which now

contains the fairly wide federal funds rate ranges to trigger Committee

consultation.

MEETING FREQUENCY

The current schedule of eight meetings per year evolved in 1981.

Its foundation was the greater focus on the monetary aggregates; meetings

around the beginning of each quarter allowed a growth rate for the up-

coming quarter to be established, and mid-quarter meetings gave an

opportunity to consider mid-course corrections. With less emphasis on the

aggregates in conducting short-run policy, this schedule could be

reconsidered.

To some extent, the desired number of meetings may depend on the

Committee's decisions on the focus of policy and discretion for intermeet-

ing adjustments. Reduced scope for adjustments between meetings might

call for more frequent meetings to calibrate policy to incoming informa-

tion, though greater telephone contact might work in the other direction.

And concern that greater attention to the federal funds rate could make

adjustments more difficult might argue for more frequent meetings to con-

sider policy alternatives. Generally, more frequent meetings have the

advantage of more timely opportunity to review new information, but they

also involve the inconvenience of more preparation and travel.

From a broader perspective, the economic fundamentals probably do

not change that much from month to month so as to require, say, monthly

9

sessions, especially considering the opportunity for telephone confer-

ences. Weighing these factors, the current schedule of eight meetings

each year might still be considered adequate.

Table 1. Difference of Funds Rate From the Desk's Expectation(Percentage points)

(All days/excluding Wednesdays/excluding Wednesdays and year-ends)

Mean StandardMean absolute deviation of

difference difference difference

Mar 14, 1984 - Mar 23, 1988 .11/.10/.06 .29/.25/.21 .65/.56/.29

Mar 14, 1984 - Oct 7, 1987 .12/.11/.07 .30/.26/.22 .68/.59/.30

Oct 21, 1987 - Mar 23, 1988 -.01/.03/.01 .20/.16/.16 .29/.21/.20

Oct 21 - Jan 13 -.06/.01/-.03 .23/.19/.18 .33/.24/.22

Jan 27 - Mar 23 .05/.07/na .15/.13/na .21/.16/na

na - not applicable1. Statistics are-based on daily data. Therefers to the last day of the reserve period.

dating of each interval

Chart 1

Volatility of the Funds Rate Around the Desk's Expectation(Standard deviation of the daily level of the federal funds

rate around the expectation for each period*)Percentage Points

0.9ekly

0.8

0.7

0.6

October 21, 1987

0.5

0.4

0.3

0.2

\ 0.1

March 23, 1988

1984 1985 1986 1987 1988

*Excludes days surrounding yearends.

Table 2. Difference of Borrowing From Path Assumption(Millions of dollars)

(Including year-ends/excluding year-ends)

Mean StandardMean absolute deviation of

difference difference difference

Mar 14, 1984 - Mar 23, 1988 49/37 124/115 167/155

Mar 14, 1984 - Oct 7, 1987 62/50 127/117 169/156

Oct 21, 1987 - Mar 23, 1988 -49/-68 105/100 111/94

Oct 21 - Jan 13 -67/-105 128/123 128/87

Jan 27 - Mar 23 -23/na 72/na 90/na

na - not applicable1. Statistics are based on reserve period averages. The dating ofeach interval refers to the last day of the reserve period.

Chart 2Deviations of Borrowing From Path

Maintenance Period Average

Actual adjustment plus seasonal borrowing*

nIIII

I

Path assumption

-I 900

October 21, 1987

z

'1

I I Iiiiiiiitliiirlllii IIii

Maintenance Period Average

Actual less path assumptionfor adjustment plusseasonal borrowing*

$ millions

1984 1985

*Excludes special situation borrowing.

1986 1987 1988

Biweekly

- I

$ millions1500

1200

March 17, 1988

Federal Reserve Policy Targetsand Operating Guides in Recent Decades: A Review*

Introduction

This report discusses the policy targets that the FOMC has followed

over the last 30 years and the operating guidelines that the Trading Desk

has used in undertaking open market operations. While the ultimate policy

goals of economic expansion with reasonable price stability have persisted

through the years, the intermediate targets have changed. Bank credit was

replaced by money at the end of the 1960s. In the 1980s, as the demand for

money seemed to change in a fundamental way, the Committee looked for new

intermediate targets. It followed a variety of indicators in an informal

way. Operating targets have changed from free reserves to the Federal funds

rate to nonborrowed reserves, and recently to borrowed reserves, a very

similar measure to free reserves.

There are interrelationships among all of the target variables and

indicators that have been used over the years. Whenever reserves have been

the primary operating target, interest rates have played a role in modifying

the response, and vice versa. However, the choice of primary targets has

had different implications for how the Federal Reserve responded to new

developments.

*Prepared by Ann-Marie Meulendyke, Manager, Open Market Analysis DivisionFederal Reserve Bank of New York. The report draws heavily on the annualreports prepared by the Manager of the System Open Market Account for the FOMCand on policy records and directives. Conversations with Peter Sternlight,Paul Meek, and Irwin Sandberg, who were at the Desk during many of the yearscovered, provided added insights. Other source material is listed infootnotes and at the end of the paper.

First half of 1960s: bank Credit and free reserves

During the first half of the 1960s, open market policy retained

essentially the same focus as in the 1950s, after the Treasury-Federal

Reserve Accord had freed the Federal Reserve to pursue an independent

1/monetary policy.- The FOMC actively pursued a contracyclical policy,

using an array of measures to evaluate economic activity. Policy instruc-

tions were general and qualitative in nature. For example, in February 1962

the FOMC directed the Desk to conduct operations "with a view to maintaining

a supply of reserves adequate for further credit expansion, while minimizing

downward pressures on short-term rates." The Committee used the behavior of

bank credit (commercial bank loans and investments) as its primary inter-

mediate policy goal. It sought to speed up bank credit growth in periods of

slow economic growth and slow it down in periods of rapid growth. Bank

credit statistics were only available with a lag, however, and thus were not

suitable for day-to-day operating guidance.

Accordingly, the weekly (or biweekly) operating objective was

couched in terms of free reserves (excess reserves less borrowed

reserves--referred to as net borrowed reserves if borrowed reserves were

greater than excess reserves). A relatively high level of free reserves

represented an easy policy, with the excess reserves available to the banks

expected to facilitate more loans and investments. Net borrowed reserves

left the banks without unpledged funds with which to expand lending, and

were viewed as fostering a restrictive policy stance. It was assumed that

1/ Until the Treasury replaced fixed price offerings with the auctiontechnique for selling coupon issues during the first half of the 1970s,the Federal Reserve agreed to follow a so called "even keel" policyduring financing periods. Around the financing periods, the Fed avoidedchanges in policy stance and tried to prevent changes in money marketconditions. Major financing operations occurred four times a year,around the middle of each quarter. However, extra unscheduled financingoperations occurred when the Treasury found itself short of money. Debtissuance was not put on a regular cycle until the 1970s.

banks would adjust loans and investments in a passive manner when reserve

availability changed.

The linkages between free reserves and bank credit were viewed at

the time as somewhat complex. High rather than rising free reserve

levels were believed to foster rising bank credit since banks would

perpetually have more excess reserves than they wanted and would keep

expanding lending. High net borrowed reserve levels would, in a parallel

manner, encourage persistent loan contraction. However, defining the point

where free or net borrowed reserves was neutral--that is fostering neither

rising nor falling bank credit levels--was believed to be possible

conceptually, but not empirically. Other factors complicating the linkage

were the distribution of reserves, loan-deposit ratios, the maturities of

bank portfolios, and the strength of loan demand. None of these

difficulties was considered fatal to the procedure so long as bank credit

growth was monitored over time.

The FOMC instructed the Trading Desk to seek a relatively steady

level of free reserves between meetings of the FOMC (usually held every

3 weeks). There was no provision for changes in the guidelines between

meetings. Reserve maintenance periods were two weeks long for country banks

(banks not located in cities with Federal Reserve banks or branches) and one

week long for reserve city banks (generally large banks in Federal Reserve

cities). Computation and maintenance periods were essentially contemporane-

ous.

Research staff members worked up free reserve forecasts each day

which gave guidance to the Desk as to appropriate reserve adjustments.

2/ See "The Significance and Limitations of Free Reserves," (Peter D.Sternlight) Federal Reserve Bank of New York Monthly Review, November1958, pp 162-167, and "Free Reserves and Bank Reserve Management."Federal Reserve Bank of Kansas City Monthly Review, November 1961, pp 10-16.

The reserve factor estimates were subject to considerable errors. Further-

more, reserves were not always well distributed across classes of banks.

Because of the errors in the free reserve forecasts and the

distribution problems, the Desk took supplemental guidance each day from the

"tone and feel of the markets" in deciding whether to respond to the signals

being given by the reserve forecasts. Reading the tone of the markets was

considered something of an art. Desk officials watched Treasury bill rates

and dealer financing costs. They factored in comments from securities

dealers about difficulties in financing positions. Desk officials were

primarily concerned with the direction in which interest rates were moving,

rather than their level, and with the availability of funding. The

justification for using market tone and feel as an indicator of the accuracy

of free reserve estimates was that if the banks were short of free reserves,

they would sell Treasury bills, a secondary reserve, and put upward pressure

on bill rates. They also would cut back on loans to dealers, thus making

financing more difficult.

The Federal funds rate played a limited role as an indicator of

reserve availability during this period although it gained attention as the

1960s progressed. The interbank market was not very broad as the decade

began, but activity was expanding. The Managers' reports of the 1960s

cited it increasingly in the list of factors characterizing money market

ease or tightness. Until the mid 1960s, the funds rate never traded above

the discount rate. During "tight money periods," when the Desk was foster-

ing significant net borrowed reserve positions, funds generally traded at

3/ Willes, Mark H., "Federal Funds During Tight Money," Federal ReserveBank of Philadelphia, Business Review November 1967, pp. 3-11; and"Federal Funds and Country Bank Reserve Management," 0p. Cit.,September 1968, pp. 3-8.

5

the discount rate, and the rate was not considered to be a useful indicator

of money market conditions. When free reserves were high, funds often

traded below the discount rate, and showed noticeable day-to-day variation.

At such times, they received greater attention as an indicator of reserve

availability.

There was considerable surprise when funds first traded above the

discount rate, briefly in October 1964 and more persistently in 1965. Why

would any bank pay more for overnight money than the Federal Reserve

charged? Such borrowing, away from the Fed, was attractive to large banks

that were becoming more active managers of their balance sheets. Though it

was not noted at the time, the changes were making free reserves an

increasingly uncertain predictor of bank credit growth as the relationship

depended upon banks responding passively to reserve availability. In 1961,

banks developed wholesale CDs, which they could use to accommodate increased

loan demand without having unused free reserves. The next logical step was

to finance loan demand by purchasing overnight Federal funds and renewing

the contract each day. Unlike CDs, takings in the funds market were not

subject to reserve requirements or Regulation Q interest ceilings. (Such

ceilings were dropped for most large CDs in 1970.) The discount window

could not be used on such a steady basis, because the Federal Reserve

continued to discourage frequent or prolonged borrowing.

The FOMC frequently had to deal with gold outflows and balance of

payments problems in these years. In 1961, it developed a procedure

designed to allow continued pursuit of domestic monetary preferences--which

at the time were for ease since the economy was just recovering from a

recession--while countering the gold outflow. The policy was referred to in

internal documents as "operation nudge" and elsewhere as "operation twist."

The Federal Reserve, in conjunction with the Treasury which altered its debt

issuance pattern, attempted to flatten the yield curve by purchasing coupon

4/securities while simultaneously selling Treasury bills.- The procedure

continued for another year and then disappeared from the discussion after

short-term rates rose in 1963. The Manager's reports focused mostly on

operational issues and reached no judgment as to whether or not the policy

was effective. Econometric studies have suggested that the effect on the

yield curve was minimal.

Second half of the 1960s; Transition to new targets and indicators

The formal policy procedures were changed only modestly over the

latter half of the 1960s, but the period was marked by questioning and

search for alternative intermediate targets and techniques for achieving

them. Inflation was a growing problem, and the Annual Reports expressed

considerable concern about the lack of tax increases (until late 1968) to

finance the Vietnam war involvement. Interest rates rose and became more

variable.

There was considerable questioning, both within and outside the

Federal Reserve, about the linkages of free reserves to the ultimate goals

of policy, and as to whether bank credit and money market conditions were

reliable predictors of economic activity. Quantitative methods were being

applied to an increasing extent to try and sort out hypothesized relation-

ships among operational, intermediate, and ultimate policy objectives. Some

of these studies suggested that more attention should be paid to money

growth and to the behavior of total reserves or the monetary base.

4/ The purchase of coupon-bearing issues followed a period from 1953 to1960 when the Federal Reserve concentrated its open market operations inTreasury bills. Previously, it had been pegging the whole Treasuryyield curve. The "bills only" policy sought to make clear that marketforces were to determine the yield curve. It was seen as having theadded advantage that Fed operations would only be a small part of thetotal, and would not measurably change floating supplies and thus nothave a big impact on rates. Twice between 1953 and 1960 coupon issueswere purchased to help "correct disorderly markets."

In response to these developments, the FOMC expanded the list of

intermediate guides to policy. Along with bank credit, the directives cited

money growth, business conditions, and the reserve base. Free reserves

continued to be the primary gauge for operations. However, borrowed

reserves received increasing weight, since excess reserve behavior was

variable and difficult to predict.

The Federal funds rate gained a more prominent position as an

indicator of money market conditions. The 1967 Manager's Annual Report

explicitly mentioned the Federal funds rate as a goal in itself rather than

just as an indicator of the accuracy of free reserve estimates. It said

that daily open market operations "focused on preserving particular ranges

of rates in the Federal funds market and of member bank borrowings from the

Reserve Banks" (page 4). The report was concerned that reserve forecast

errors might lead to unintended money market firmness which market partici-

pants could misinterpret.

The FOMC met every 3 to 4 weeks, but it was still concerned that

developments between meetings might alter apprcpriate reserve provision. In

1966 it introduced what was called a proviso clause, which set forth

conditions under which the Desk might modify the approach that had been

adopted at the meeting. It would have preferred to use bank credit as the

trigger to change money market conditions, but data were available only with

a lag. Hence, it used a proxy for bank credit in the proviso clause. After

some experimentation, it adopted what it called the bank credit proxy, which

consisted of daily average member bank deposits subject to reserve

requirements.

Logically the bank credit proxy, which represented most of the

liability side of the banks' balance sheets, should have moved in a similar

fashion to bank credit, which was a large share of the asset side of their

balance sheets, but they often differed. One source of distortion was the

growing use of nonreservable liabilities to finance credit extension. Banks

encountered rising interest rates as inflation heated up, and Regulation Q

often limited their ability to raise rates enough to attract deposits.

Furthermore, higher interest rates made reserve requirements more burden-

some. Consequently, banks raised money in the Eurodollar market to finance

lending. In 1969, the bank credit proxy was expanded to include liabilities

to foreign branches, the largest nondeposit liability. Nonetheless, the

proxy continued to deviate from bank credit as reserve ratios changed.

Whenever the bank credit proxy moved outside the growth rate range

discussed at the FOMC meeting, the Desk typically adjusted the target level

of free or net borrowed reserves, say by about $50 million according to

present rough recollections. Sometimes the proviso clause permitted either

increases or decreases in the objective for free reserves. Frequently it

allowed adjustments only in one direction.

To decide each day on its operations, the Desk looked at the

reserve forecasts, short-term interest rates and availability of financing

to the dealers. If there was a need for reserves that was confirmed by a

sense of tightness in the markets, the Desk would respond soon after the

11 o'clock conference call. It used a larger share of outright transactions

than currently, partly because it engaged in less day-to-day fine tuning,

but it did make active use of RPs and, after their introduction in 1966, of

matched sale-purchase transactions. In 1968, lagged reserve accounting was

introduced, based on deposit levels from two weeks earlier, with all banks

settling weekly. The change made it easier to hit free reserve targets,

ironically, shortly before free reserve targeting ended.

1976 to 1979: Targeting money growth and the Federal funds rate

In 1970, money growth formally replaced bank credit as the primary

intermediate target of policy, and the Federal funds rate replaced free

reserves as the primary guide to day-to-day open market operations. The

transition was gradual, with the first few years of the decade characterized

by frequent experimentation and modification of the procedures. Nonetheless,

the framework until October 1979 generally included setting a monetary

objective, and encouraging the funds rate to move gradually up or down if

money were exceeding or falling short of the objective.

Bank credit and its proxy continued for a while in the list of

subsidiary intermediate targets, but they received decreasing attention.

The Desk also continued to watch the behavior of both free and borrowed

reserves, mostly as an indicator of how many reserves needed to be provided

to keep the Federal funds rate at its desired level. They exploited the

positive relationship between borrowing and the spread between the funds

rate and the discount rate. The relationship was imprecise, but it gave the

Desk an idea of how many free or net borrowed reserves were likely to be

consistent with the intended funds rate. The Desk could continue to make

use of the forecasts of reserve factors to gauge the appropriate direction

and magnitude for open market operations.

Initially in 1970, the FOMC selected weekly tracking paths for Ml,

based upon staff projections of likely behavior. It simultaneously

continued to specify desired growth of the bank credit proxy, and also

indicated preferred behavior for M2, but those measures received less weight

than M1. 5/ It instructed the Desk to raise the Federal funds rate within

a limited band if the monetary aggregates were well above the tracking path

or to lower the funds rate within that band if the aggregates were below the

tracking path.

5/ At the time, M1 consisted of currency and privately held demand deposits.Other checkable deposits were added in 1980. M2 consisted of M1 plustime and savings deposits at commercial banks other than large CDs.Thrift institution deposits and overnight RPs and Eurodollars and moneymarket funds were not included until 1980.

In 1972, a number of significant modifications were made. The

weekly tracking path for M1 was supplemented (and was later replaced) with

two-month growth rate ranges running from the month before to the month

after the FOMC meeting. The change was designed to reduce the weight given

to the rather volatile weekly money numbers and to quantify significant

deviations. At the end of that year, the Committee also sharpened the

distinction between targeting desired money growth and targeting expected

money growth. Initially, the M1 tracking path had been based on Board staff

expectations. If the projected money growth was too high to sustain the

desired noninflationary growth, no effort was made to set the tracking path

below the projection. By late 1972, the Committee took note of that

failing. It introduced six-month growth targets for the monetary aggregates

explicitly designed to be consistent with economic activity and price

goals.

In 1972, the FOMC also introduced a reserve operating mechanism to

be used simultaneously with the interest rate guideline. Funds rate target-

ing was recognized as suffering from an obvious weakness. The staff had to

estimate what funds rate would achieve desired money growth. The funds rate

worked by affecting the interest rates banks both paid and charged customers,

and in turn the demand for money. But the demand for money was also a

function of nominal income and expectations about inflation. The Board

staff built models of money demand as did other Federal Reserve research

departments. There was much debate about these models and their accuracy

through the decade. Some observers felt that the models would have done

well enough over periods of meaningful length, considered to be six months

to a year, if the FOMC had really allowed interest rates to move as much as

the models required. Others felt that it was not practical to control money

adequately by working through the demand side, either because the models

were not reliable enough or because the interest rate consequences threatened

to be too disruptive to markets.

The other potential approach to monetary control, which was widely

touted in the academic community, was to work from the supply side. If the

provision of total reserves were controlled, it was argued, then money

growth would be constrained through the reserve requirement ratio. There

was concern, however, that the approach would cause undesired short-run

volatility of interest rates. To limit money market volatility, the FOMC

tried reserve targeting but with a constraint on the funds rate.

One technical problem was that total reserves were subject to

change for reasons unrelated to money growth. In particular, interbank and

Government deposits were excluded from all the money definitions, but were

subject to reserve requirements. Government deposits varied far more than

they have in recent years. All tax and loan account monies were kept in

demand deposits subject to reserve requirements until 1977 when a legal

change permitted note option accounts which pay interest and are not subject

to reserve requirements. To take account of the reserve requirements on

deposits not in the money definitions, the Federal Reserve developed a

measure called reserves on private deposits or RPD. While RPD behavior was

closer to that of M1 than was total reserves, the linkage was not very close

because reserve requirements differed widely according to the size and

membership status of the bank. Movements of deposits between large and

small banks or member and nonmember banks changed the ratio of RPD to Ml.

Changes in the ratio of currency to deposits also affected the relationship

between RPD and Ml.

The FOMC set two-month growth target ranges for RPD based on staff

estimates of the various ratios and instructed the Desk to alter its reserve

provision in a way designed to achieve them. The actions were also supposed

to be consistent with achieving a specified Federal funds rate each week,

which could be moved within a band between meetings. Usually the band was

1 to 1 1/4 percentage points wide. Intermeeting intervals were 4- to

5-weeks long. Unfortunately for the experiment, the relatively narrow funds

rate constraint often dominated, and the Desk frequently missed the RPD

target. RPD targets were declared unachievable, although the funds rate

constraint precluded a true test. In time, RPD's status changed from

operational target to intermediate target, where it took its place along

with M1 and M2. Since information was about as good on the behavior of M1

as it was on RPD, RPD gradually fell into disuse. It was dropped as an

indicator in 1976.

Subsequent modifications to techniques mostly related to the nature

of the monetary targets. In 1975, under pressure from the Congress, the

Federal Reserve adopted annual monetary target ranges and announced them

publicly. A growth cone was drawn from the base period which was the

calendar quarter most recently concluded. Each quarter, the target range

was moved forward one quarter. The procedure meant that by the time the

annual target period was completed, the target had been superseded.

Frequently, the targets were overshot, and complaints about upward base

drift were legion. The "Humphrey-Hawkins" Act of 1978 established the

current procedure which required the Federal Reserve to set targets for

calendar years and to explain any misses.

Along with the annual targets set in February and reviewed in July,

the Committee, as noted, also set two month ranges. In theory, the two-

month money growth targets were supposed to be consistent with returning to

the annual target range if the money measures were outside the range, and

with holding the aggregates within the ranges if they were already there.

In practice, if the changes in the funds rate that the staff estimated were

likely to be needed to get money back on target were unacceptable to the

Committee, it would approve growth rates that stretched out the period for

bringing money back on track, or even acknowledge that target growth

probably would not be achieved within the year.

As the decade progressed, the control of the Federal funds rate

tightened. The range set to guide the Desk between meetings tended to

narrow, and changes made at the meetings generally were small. Frequently,

the range surrounded the most recent funds rate target. In the early 1970s,

according to current recollections, the intermeeting funds rate range was

generally 5/8 to 1 1/2 percentage point wide. By the latter part of the

decade, its width was usually about 1/2 to 3/4 percentage point, and on a

couple of occasions only 1/4 percentage point. In addition, the aggregate

ranges were often set in a way that made it likely that the funds rate would

only move in one direction, effectively cutting the range in half.

In implementing the funds rate targeting procedure, the Desk became

increasingly sensitive to preventing even minor short-term deviations of the

funds rate from target. It felt some constraint not to make reserve

adjustments in an overt way unless the funds rate moved off its target.

When reserve estimates suggested a large adjustment was needed but the funds

rate did not confirm it early in a statement week, the Desk would worry

about the feasibility of doing a very large open market transaction late in

the week. The Desk increasingly used internal transactions with foreign

accounts and, after they were introduced in 1974, it used customer RPs to

add reserves at times when the funds rate was on target but a reserve need

was projected. (Market participants were accustomed to reading no policy

significance to outright transactions for customers and initially regarded

customer RPs the same way.)

If the need was too large for these techniques, the Desk often

pounced on very small funds rate moves off target. A 1/16 percentage point

deviation would lead the Desk to arrange an RP or MSP transaction if the

rate move were in the direction consistent with the reserve estimates. If

the funds rate moved off target in the "wrong" direction, the Desk typically

would allow a 1/8 percentage point deviation before it would feel forced to

do a small operation. There was an operational limit to how late in the day

transactions could be done for same day reserve effect. The cutoff was

supposed to be 1:30 p.m., but if the desired funds rate move occurred just

after that time, the Desk responded if it was anxious to do an operation.

The end of its operating time was close to 2:00 p.m. by 1979.

The Desk's prompt responses to even small wiggles in the Federal

funds rate led banks to trade funds in a way that kept the rate on target.

Except near day's end on the weekly settlement day, a bank short of funds

would not feel the need to pay more than the perceived target rate for

funds. Likewise, a bank with excess funds would not accept a lower rate.

Rate moves during the week were so limited that they provided little or no

information about reserve availability or market forces. Probably few, if

any, in the Federal Reserve really believed that brief small moves in the

funds rate were harmful to the economy. The tightened control developed bit

by bit without an active decision along the way.

1979 to 1982; Monetary aggregates and nonborrowed reserves

In October 1979, the FOMC radically changed the way it operated to

achieve the monetary targets. It explicitly targeted reserve measures

derived to be consistent with desired quarterly growth rates of M1. The

constraint on the Federal funds rate applied only to weekly averages, and

not to brief periods during the week. It was set wide enough to allow

significant adjustments if needed to achieve the monetary target.

Persistent overshoots of money targets and severe inflation had changed

priorities. Interest rate volatility, so feared when the RPD targets were

developed in 1972, seemed more tolerable.

Operationally, the FOMC chose desired growth rates for Ml (and M2)

that covered a calendar quarter and instructed the staff to estimate

consistent levels of total reserves. The process resembled that used to

estimate RPDs. The staff estimated deposit and currency mixes to derive

average reserve ratios and currency-deposit ratios. They used econometric

models supplemented by some judgment. From the total reserve target, the

Desk derived the nonborrowed reserve target by subtracting the initial level

of borrowed reserves that had been indicated by the FOMC. The initial

borrowing level was intended to be consistent with the desired money

growth. If it were not, money and total reserves would exceed or fall short

of path. If the Desk only provided enough reserves to meet the nonborrowed

reserve path, borrowing would automatically rise if money growth (and total

reserve demands) were excessive, or fall if such growth were deficient. The

borrowing move would affect reserve availability and the funds rate, and

encourage the banks to make adjustments that would accomplish the desired

slowing or speeding up of money growth.

To reduce overweighting of weekly movements in money, the total and

nonborrowed reserve paths were computed for intermeeting average periods, or

two subperiods if the intermeeting period were long. (In 1979 and 1980 the

FOMC met 9 and 10 times; in 1981 it moved to the 8 meeting schedule in use

today.) The price paid for this averaging technique was that errors in the

early part of the period had to be offset by large swings in borrowing in

the final week. Informal adjustments were made to eliminate these temporary

spikes or drops in borrowing that were deemed inconsistent with the longer

term pattern. While the adjustments were considered necessary to avoid

severe swings in reserve availability and interest rates, they gave the

appearance of "fiddling" and have led to considerable confusion in the

literature. Each week the total reserve path and actual levels were

reestimated, using new information on deposit-reserve and deposit-currency

ratios.

In implementing the policy, the Desk emphasized that it was

targeting reserves and not the funds rate by entering the market at a

standard time to perform its temporary operations. It confined outright

operations to longer term reserve needs and arranged them early in the

afternoon for future delivery. The Federal funds rate was not ignored. It

was used as an indicator of the accuracy of reserve estimates, although it

was not always that reliable. On the margin, it could accelerate or delay

by a day or so the entry to accomplish a needed reserve adjustment, but its

role was much diminished.

While the wider swings that occurred in the Federal funds rate had

been expected, the extent of the swings in the short-term growth rates of

the monetary aggregates came as something of a surprise. In part, the sharp

movements in both interest rates and money probably reflected the underlying

conditions. The effort to turn around almost 1 1/2 decades of building

inflationary expectations, which had come to permeate economic relation-

ships, forced major adjustments. Expectations about inflation and economic

activity were very fluid, and subject to sharp swings as people tried to

evaluate all of the adjustments and new information.

The control mechanism itself almost assured that money growth would

cycle around a trend. Every time money rose above its desired level,

borrowed reserves would rise automatically. They would not decline until

money growth, and hence total reserve growth, started to slow. The higher

borrowing would slow money growth, but with a lag. By the time borrowing

finally fell, it would have been high too long, assuring that money growth

would fall below the desired level. The risk of overadjustment of money had

been recognized from the beginning. Some saw it as a necessary antidote to

the earlier procedure which moved the funds rate too little too late.

1983 to the present: Monetary and economic objectives with borrowed reservetargets:

A breakdown in the relatively close linkage between M1 and economic

activity, rather than dissatisfaction with the procedures, led to the next

set of changes, although there was also some sentiment that short-term rate

volatility had been excessive. By the latter part of 1982, it was becoming

apparent that the demand for money, particularly M1, was rising, and the

relatively limited growth being sought to break the inflationary cycle was

more restrictive than recent experience would have suggested. Some of the

increase in the demand for money was attributed to the ongoing deregulation

of interest rates on various classes of deposits. NOW accounts were making

it more attractive to hold savings in M1. The FOMC had hoped that M2 would

continue to be a reliable indicator, and for a few months at the end of 1982

it attempted to use it as a guide to building total and nonborrowed reserve

targets. However, MMDAs, which were authorized beginning in December 1982,

proved very attractive, and the demand for M2 rose sharply.

The FOMC followed ad hoc procedures hoping that they would prove to

be temporary until the behavior of the aggregates settled down. The FOMC

focused on measures of inflation and economic activity to supplement the

aggregates. Instead of seeking total reserve levels directly linked to some

aggregate and deriving a level of borrowing that moved with the deviations

of the aggregate from target, it chose the borrowed reserve level directly,

with the intention of adjusting it up or down whenever money seemed to be

deviating in a meaningful way (after making allowance for distorting factors

and taking account of the supplemental indicators).

The monetary aggregates did not quickly resume their prior relation-

ship with economic activity. Declining inflation made holding money more

attractive, and interest rate sensitivity increased, since rates on some

components of M1 were close to market rates but slow to change. Policy

decisions continued to be guided by information on economic activity,

inflation, foreign exchange developments, and financial market conditions.

In time, money growth itself joined the list of factors shaping adjustments

to the borrowing level. What started out, apparently, as a temporary

procedure has persisted, with modifications, for over five years.

There is clearly some resemblance between targeting borrowing and

targeting free or net borrowed reserves as was done in the 1950s and

1960s. As in the 1960s, the reserve forecasts played an important role

in the decision each day as to whether to provide or drain reserves. Money

market conditions, this time specifically the funds rate, have supplemented

the reserve forecasts, particularly in choosing the days on which operations

are conducted and the instruments used to make the reserve adjustments.

6/ Mechanically, the only difference is excess reserves. Estimating thedemand for excess reserves became more complex in the 1980s when theMonetary Control Act extended reserve requirements to nonmember banksand thrifts.